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When it’s raining dollars, how can we deal with the problem of plenty?

When it’s raining dollars, how can we deal with the problem of plenty?
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First Published: Mon, Jul 02 2007. 02 25 AM IST
Updated: Mon, Jul 02 2007. 02 25 AM IST
Last week, our friend Johnny came across a forecast that talked about dollars raining down. Johnny is confused about the implications of continuous deluge of forex inflows. He is happy that we can at least boast of abundance. But he is not sure why some people call it a problem of plenty.
As usual, he started a discussion with Jinny to clear his doubts.
Jinny, first of all, told him about different sources through which dollars are pouring in the country. Continuing their talk, they are now discussing why management of excess inflow poses a challenge for policymakers.
Jinny: Excess inflow of dollars, like excess rainfall during the monsoon, can pose a problem of plenty if you don’t know how to put them into the right channels. Your domestic currency may start appreciating under the pressure of heavy inflows, which may hurt your exports.
Some people feel that just like monsoon rains, which we store in dams, dollar inflows can be saved in the form of reserves for future use. You may be aware that in 1991, India had a forex reserve of only $5.8 billion (Rs23,780 crore), which was not sufficient to cover imports of more than three weeks.
Now our forex reserves have crossed the figure of $210 billion. But nobody can predict what level of forex reserves would?be?more than necessary.
Some experts feel that things can go wrong any time. As you have seen, investments by foreign institutional investors (FIIs) in the stock markets constitute a substantial part of the total foreign exchange inflows. Net FII inflows each year have been around $9-10 billion in recent times. The level of our reserves should be sufficient to meet any worst-case scenario arising out of a sudden capital flight.
Johnny: True. Then we should keep on building the reserves. What’s the problem?
Jinny: The problem is that management of dollar inflows imposes cost. The country’s central bank has to keep intervening in the market for purchasing dollars. Experts have a special name for such frequent intervention by the central bank in the forex market: “dirty float system of exchange rate management”.
Frequent intervention by the Reserve Bank of India (RBI) prevents the domestic currency from appreciating. This no doubt to some extent can boost exports. But frequent dirty floats come with a cost.
First, the foreign currency assets purchased by RBI may earn lower interest than the domestic currency assets. This is because forex reserves are kept in the form of securities of foreign governments, deposits with other central banks and deposits with foreign banks, all of which are safe modes of investment, but typically earn lower interest.
Second, for purchasing dollars, RBI has to sell the domestic currency. Selling of domestic currency increases money supply in the economy, which in turn causes inflation. For controlling money supply, RBI has to carry out sterilization, which again imposes cost.
Johnny: You talked about dirty float first, now sterilization. Is the sterilization required to kill the germs coming out of the dirt?
Jinny: Not the germs exactly. Simply put, sterilization is done by selling securities in the market, which allows the central bank to absorb the liquidity. However, there are two problems. First, selling of securities entails cost in terms of interest paid to the purchasers. Second, the stock of securities available with the central bank, at one point or the other, is likely to get exhausted.
To overcome the second problem, in India, RBI started the Market Stabilization Scheme from 1 April 2004, in which securities are issued specially for carrying out sterilization.
Johnny: Well, sterilization solves just one problem. You said our forex earns less interest when deployed in the securities of another countries. Why can’t we put our forex to more productive use in some alternative avenues?
Jinny: There has been no dearth of suggestions about this. Some experts suggest that we should create investment vehicles on the lines of Temasek Holdings and Government of Singapore Investment Corp. for investing our forex in riskier assets for generating good returns.
But the point is, what is the purpose of creating forex reserves? Do we create reserves for generating profits through investments or do we create reserves for bailing us out in case of need? We need to look at all the pros and cons before taking any decision. This year’s Union Budget proposed to create subsidiaries of the Infrastructure Finance Co. for borrowing foreign currencies from RBI to invest in domestic infrastructure projects. We have yet to see how this proposal works out.
Johnny: Well Jinny, I think the debate for managing the forex can go on and on. Let’s not forget that it is better to get soaked in the rain than to sit idle and scratch our heads. I think the rising forex will one day teach us the art of eating?our cake and saving it, too.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Mon, Jul 02 2007. 02 25 AM IST